Shutdown 101: Discretionary spending’s implication for investors

The below graph reflects the trend in the discretionary component of US government spending as a percentage of US gross domestic product (or GDP). This type of spending had declined from roughly 10% of US GDP to 6% of US GDP as the Cold War with Russia ended post-Reagan. However, the recent war in Iraq and military operations in Afghanistan have contributed to the resurgence in defense spending in recent years. This article examines the components of discretionary spending within the context of growing debt levels in the US and considers the implication for US investors.

Data lag

As a result of the appropriation of funds prior to 2011, discretionary spending posted a dramatic increase during the Obama Administration. However, the Congressional Budget Office (or CBO) estimates that, in fact, total discretionary funding (budget authority plus obligation limitations) in 2011 was the lowest as a percentage of GDP since 2002. So it’s important to note that, after adjusting for prior appropriations versus current appropriations and actual spending, both current and future discretionary spending levels are expected to decline significantly. Also, due to the Budget Control Act of 2011, instituted caps on discretionary appropriations are in place from 2012 through 2021. These measures will likely keep future spending around 2011 levels, which are more in line with 2002 levels on a real-time spending versus lag-time appropriation basis. So it’s likely that discretionary spending is on its way back to Clinton Era levels. However, it’s important to note that the Budget Control Act doesn’t constrain the budget for specific defense needs such as Afghanistan. Though the rest of the defense budget is essentially capped at 2% growth rates—essentially in line with inflation.

Playing defense: More butter, fewer guns

The chart below reflects the composition of discretionary spending. While the Republican Party tends to favor a strong defense budget relative to the Democratic party, the Obama Administration will likely have to push harder on the defense portion of discretionary spending to pay for its Affordable Health Care Act (Obamacare), or simply increase the US debt, as is currently being discussed. Given the relatively small proportion of discretionary spending claimed by other areas of the federal government, such as health and education, it may be challenging to expect further cuts in these areas. However, as Larry Kudlow points out, if 20% of government workers are currently considered non-essential, perhaps they could be rendered permanently non-essential and find employment in the private sector.

(Source, CBO)

Floating liability

Given the ongoing issues in Syria and Iran—not to mention the ongoing activity in Afghanistan—significant potential liability remains in the area of discretionary spending. Despite the Budget Control Act of 2011, which is intended to keep discretionary spending flat relative to GDP, there remains the spending exception of defense-related matters. Should adverse developments occur in Syria or Iran, the post–Cold War peace dividend could be compromised, and the Clinton-Era levels of discretionary spending to GDP of 6% may not be realized. In the current economic environment, with Obamacare in place, additional emergency expenses in the area of defense will likely go right to the growth in the US debt on a dollar-for-dollar basis. In other words, with Obamacare in place, taking up to an additional $100 billion per year in the early years, an emergent $100 billion request for additional military operations in the Middle East could become financially challenging.

While estimates suggest Obamacare will likely save $20 billion a year during the first ten years, and $50 billion per year over a 20-year period, initial outlays are estimated at $1.1 trillion in the first ten years—just over $100 billion per year. The president’s defense budget for 2012 came in at $553 billion—well below the $664 billion seen in 2011, due to “overseas contingency operations.” In other words, “contingency operations” can easily match the size of the entire cost of Obamacare, and in the current environment of low tax receipts, an additional $100 billion per year in contingency costs might be difficult to bear. Clearly, should the defense budget have to increase to deal with emergent global situations, we would likely see another round of Republican pressure to provide funding growth in defense against cuts in entitlements—the $100 billion Obamacare item seems to be the perfect number.

Shutdown investing: Outlook

Should Congress and the President fail to make progress on budget discussions, investors may wish to consider limiting excessive exposure to the US domestic economy, as reflected more completely in the iShares Russell 2000 Index (IWM). Alternatively, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD). Plus, even the global blue chip shares in the S&P 500 or Dow Jones could come under pressure in a rising interest rate environment accompanied by sequester-driven declines in consumption, investment, and economic growth. So investors may exercise greater caution when investing in the State Street Global Advisors S&P 500 SPDR (SPY), Blackrock iShares S&P 500 Index (IVV), or the State Street Global Advisors Dow Jones SPDR (DIA) ETFs. Until consumption, investment, and GDP start to show greater signs of self-sustained growth, investors may wish to exercise caution, and consider value and defensive sectors for investment.